Wednesday, October 07, 2009

What went wrong: David Gruen


''It is as if, as the Titanic was sailing into iceberg-infested waters, those with the requisite skills and training to warn of the impending danger were instead hard at work, in a windowless cabin, perfecting the design of ship hulls … for a world without icebergs.''

Gruen is the had of macroeconomics at the Treasury.

He could be fronting the Senate inquiry this Friday.

Mark Davis profiled him for the Age:

PATHOLOGIES are unwholesome phenomena, abnormal and irregular conditions that disrupt the healthy order of things. In physiological systems, they cause disease. In psychological manifestations, they can give rise to personality disorders. And in the body politic, entire societies have fallen under the sway of pathologies such as totalitarianism.

Pathologies are not the kind of things that normally figure prominently in the highly rational world of David Gruen. Yet since the onset of the global financial crisis a year ago this week, they have been much on the mind of this senior Treasury official.

Gruen believes that for years the world's best and brightest economic minds, preoccupied with abstract models of how economies function, have paid far too little attention to the real-world role of economic pathologies - aberrations such as house price bubbles, excessive risk-taking by investment banks or the financial panic that gripped markets when America's fourth-largest investment bank, Lehman Brothers, collapsed last September.

Gruen is part of the creme de la creme of Australia's macro-economics fraternity - an economic elite who typically work in the upper echelons of governments, central banks and academia. They specialise in the big picture. What causes fluctuations in economic output, unemployment and inflation? Why do economies go through booms and busts? Can governments smooth these cycles and so improve the welfare of households and businesses?

The irony, Gruen tells The Age, is that it was ''pathologies'' in the Great Depression - crashing stockmarkets, panic-stricken investors hoarding funds - that gave birth to macro-economics in the first place...

''Yet the discipline just left that behind,'' he says. Instead, macro-economics concentrated on explaining economic fluctuations in terms of models in which individuals and firms were always well informed, always had a highly sophisticated understanding of what was going on in the economy - and always acted rationally.

In a speech earlier this year, Gruen used a
memorable metaphor to describe the problem. ''It is as if, as the Titanic was sailing into iceberg-infested waters, those with the requisite skills and training to warn of the impending danger were instead hard at work, in a windowless cabin, perfecting the design of ship hulls … for a world without icebergs.''

Gruen's assessment is all the more telling in that it is not the critique of a heterodox economist but a view from well inside the economic orthodoxy. A former head of the Reserve Bank of Australia's research department, Gruen is executive director of Treasury's macro-economics group, one of Treasury secretary Ken Henry's deputies, responsible for advising governments on the state of the economy.

While he and his colleagues have grappled for the past year with policy measures to ameliorate the crisis, Gruen has also been pondering the wider implications of the episode for his discipline.

In the process he has engaged in an intellectual mea culpa.

He believes the latest crisis should prompt a transformation of macro-economics, just as the Great Depression and 1970s stagflation - the paradoxical coupling of slow growth with high inflation - were catalysts for earlier overhauls in the field.

Tall and sinewy with the fidgety demeanour of someone brimming with intellectual energy, Gruen is one of Australia's economic policy insiders.

His late father, Fred, was an elder statesman of Australian economic policy. Fred arrived in Australia as one of the ''Dunera boys'' - refugees from the Nazis who came to Australia aboard the British vessel Dunera and were interned because of their Austrian and German extraction. He rose to become an economics professor and adviser to former Labor prime minister Gough Whitlam.

David's brother, Nicholas, also an economist, has worked at the Productivity Commission and the Business Council of Australia and is now a consultant.

Yet Gruen's pathway into the discipline was unconventional. After enrolling in science at Monash University in the 1970s, he tried a half-year course in economics but didn't like it. ''I found it much less satisfying than the science I was doing,'' he says.

He specialised in biophysics and took a PhD at Cambridge University in 1980. ''I was doing mathematical modelling of biological membranes,'' he says matter-of-factly. His doctoral thesis was titled: A statistical mechanical study of the adsorption of non-polar molecules into lipid bilayer membranes.

After Cambridge, Gruen spent four years as a researcher at the Australian National University's applied mathematics department before deciding at the age of 29 to give economics another try.

''I thought my father had an interesting life, and economics seemed like a more interesting discipline. It had a lot to do with the real world and it was kind of broadening, whereas what I was doing in science at that time was increasingly focused and narrow.''

A graduate diploma and a PhD in economics followed. Gruen followed his girlfriend, now wife, Jenny Wilkinson, to the Reserve Bank, and both then spent two years in the early 1990s at Princeton University, where Gruen sat in on economics courses taught by leading American economists Ben Bernanke, Kenneth Rogoff and John Campbell.

He returned to the RBA and headed its research department before moving to Treasury in 2003, about the time the pressures were starting to build in the financial systems of North America and Europe.

Gruen says most economists saw little to fret about in developments such as global imbalances that involved huge flows of funds going from developing to developed countries, or in the way low interest rates fuelled strong rises in asset prices, as happened with the US house price bubble.

''I think economists prefer economic explanations for things,'' he says. ''So if you have something like a big rise in house prices and you have one set of people saying, 'Well, this is irrational and people have massively overdone it', and then another set of people saying, 'No, I can explain why house prices are so high for these fundamental economic reasons.' I think economists have a kind of in-built preference for being influenced by fundamental explanations.''

MAINSTREAM economists, he says, are uneasy with the idea that there can be asset price bubbles lasting a relatively long time even in markets where investors have plenty of information to make judgements about the value of assets. ''The idea that there is something unsustainable going on, it gets into the realms of psychology rather than mainstream economics, and so economists are uncomfortable with it.''

The favoured tools of macro-economists have been abstract theories and sophisticated models that condense the decisions of the numerous economic actors in modern societies into systems of equations and mathematical relationships. Until the latest disaster, Gruen and his peers in the global macro-economics club could claim considerable success. After the turmoil of the 1970s and 1980s, advanced economies, especially in the English-speaking world, experienced long stints of growth, the defeat of inflation and stronger employment outcomes.

Intellectual disputes in the discipline had been settled and replaced with consensus on how economies worked and the proper role of policy.

Even as financial markets were on the brink of collapsing, in August last year, one of the club's most prominent members, Olivier Blanchard, now director of the International Monetary Fund's research department, said in an essay surveying the field: ''The state of macro is good.''

But the failure of economists to predict the financial implosion and the severity of the resulting global recession have prompted a rethink.

This debate has focused on two issues: the macro-economic models used by policymakers in governments and central banks, and the ''efficient market hypothesis'', which holds that market prices of financial assets are the best available estimates of their real value.

''The mainstream of macro-economics and finance has been taken up for several decades with how to model the behaviour of rational, far-sighted individuals who understand the environment they are in,'' Gruen says. ''Unexpected things happen to them, but they are completely comfortable with the economy in which they find themselves and they can therefore behave optimally.''

The development of these models has been the culmination of a ''grand project'' arising out of the intellectual disputes in the 1970s. This project aimed to uncover micro-economic foundations - theories grounded in the behaviour of individual economic agents - for macro-economic models of the whole economy.

But Gruen now says the grand project ''has given too much credence to rational behaviour and being far-sighted, having a sense of exactly how the world is going to play out.''

''[In the models] there are going to be shocks, but here is the economic structure and all you have to do is solve this complicated economic structure and then you will know what to do … Nothing pathological happens.''

The efficient market hypothesis was another theoretical construct believed by its supporters to be strongly backed by empirical evidence. In fact, Gruen says, it ended up obscuring economists' views of the real world. One of the giants of modern economics, Robert Lucas, argued recently that criticisms of the discipline's performance in light of the financial crisis were misplaced. Lucas deployed the efficient-market hypothesis to argue that no economic model can predict sudden falls in asset prices.

But Gruen believes this misses the point.

''It's not about being able to predict financial prices from one week to the next. It's about being open to the possibility that in a well-functioning economy like the United States - not an economy with hyperinflation, not an economy with a world war going on, none of those things happening - house prices for the whole country can get 30 per cent out of line and at some point that will just unwind, which has massive implications.

''The point of the efficient markets hypothesis is that sort of stuff is not supposed to happen.''

Gruen acknowledges that the ''grand project'' to build macro-economics on solid micro foundations chalked up spectacular successes. But he wonders whether those very achievements contained the seeds of the latest failure.

One of the key policy prescriptions macro-economists developed in response to the high inflation of the 1970s was to give central banks more independence. ''And indeed,'' says Gruen, ''inflation did come down and that was a huge success story.''

This was followed by an extended period of low inflation and stable growth that macro-economists dubbed the great moderation: ''The idea that, with independent central banks, we had entered a new world where business cycles may not have been eliminated but they had been tamed.''

Thus lulled, economists also paid less attention to the issue of financial market regulation.

''There was a broad view … that well-resourced financial firms can be pretty much left to their own devices,'' Gruen says. ''That was something the City of London prided itself on. There was an intellectual view that the light-touch regulation by the Financial Services Authority in the United Kingdom was part of the key to the success of the City of London.

''So the macro-economy was more stable and financial regulation wasn't that big a deal, it was just stifling innovation. But what in fact was happening was that imbalances were building up that were going to blow the top off the whole thing.''

So what is the way forward for the chastened macro-economists' club?

Asset price booms are a key issue - how to distinguish between those that reflect economic fundamentals and those that are unsustainable - and what to do about the latter.

But Gruen admits the answers are far from obvious.

Behavioural economists have incorporated insights from cognitive psychology into economic models. But this research is yet to deliver a paradigm shift, Gruen says. And expecting central bankers to use interest-rate policy to deflate bubbles is easier said than done.

In an asset price bubble, Gruen points out, investors expecting to earn 15 or 20 per cent returns on their funds are unlikely to be deterred by increases in official interest rates of half a percentage point.

''If you tighten monetary policy early and the bubble keeps growing, what do you do then? You've managed to slow the economy down, unemployment has risen a bit, and the bubble is still growing.

''You can't drive the economy into the ground,'' he says.

The way forward may not be clear, but in the end this physiologist turned macro-economist has a disarmingly modest aspiration for how economics might develop in the wake of the crisis.

''The hope is that the discipline will be invigorated and find the real world interesting again - rather than being stuck in that windowless cabin.''

DAVID GRUEN CV

BORN Sydney 1954.

FAMILY Married to economist Jenny Wilkinson. Children: Angus, 13, Jessica, 11, Emma, 7.

EDUCATION Haileybury College; Monash University; Cambridge University; Australian National University.

CAREER 1980-2009 Research scientist, ANU; visiting lecturer, Princeton University; economic research department, Reserve Bank; senior executive, Treasury. Current position executive director, macro-economic group, Treasury.

INTERESTS Chess, bushwalking and skiing.

Mark Davis is national editor.


Published in the Age


1 comments:

carbonsink said...

The solution to an asset price bubble is an asset price bust. Australians will not stop borrowing to the hilt for investment properties until there is a bust. Until people know that house prices can fall, the bubble will just keep inflating.

So what did we do when house prices started to fall last year? We propped them up with all kinds of government handouts, that's what. The GFC has reinforced the belief in many Australians that we are the only country in the world where house prices cannot fall, which only sets us up for a bigger crash in the future.

P.S. Getting rid of rorts like negative gearing and the CGT concession would help prevent future asset bubbles as well, but we all know that won't happen.

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